(1) Draw an indifference curve map with the quantity of pennies are on the horizontal axis and the quantity of nickels are on the vertical axis. Given the shape of your indifference curve, how would you describe the typical relationship between these two “products”?

The two goods are perfect substitutes for each other. 5pennies are equivalent to a nickel.

(2) You and I are in consumer equilibrium. CDs cost 10 dollars each and cassette tapes only 2 dollars each. I consume CDs and cassettes. You consume only cassettes. What can you infer about my MRS (marginal rate of substitution) of CDs and tapes? What about your MRS.

Since both individuals are in consumer equilibrium, for you, the MRS should equal the price ratio since you consume both goods. Hence MRS = 10/2 = 5. For me since I consume only cassettes at my equilibrium, it implies that I consider CD’s a neutral good. Therefore my indifference curves are horizontal (assuming CD’s are on the horizontal axis). Hence MRS is zero, since no amount of increase in CD’s can change your utility unless you have more cassettes.

(3) The price of driving a car is 30 cents per mile. The cost of riding the bus is 60 cents per mile. At the moment, your Marginal Utility of the last mile of car transportation is 80 units, and the Marginal Utility of your last mile of bus transportation is 150 units. Are you maximizing your utility? Explain your answer.

If I’m maximizing my utility then the marginal utility derived from the last cent spent on each good must be equal.

The marginal utility from the last cent spent on driving a car is = 80/30 =8/3=2.67 The marginal utility from the last cent spent on riding the bus = 150/60 =5/2=2.5 Hence I’m not maximizing my utility. I can increase my utility by spending less on bus rides and more on driving the car.

(4) Let’s say your consumption basket is made up of two goods, “X” and “Y”. Your income is “I”. The market prices you face for these two goods are PX and PY. Draw an initial equilibrium point for your consumption of these two goods. (Restate the formula for the relation between your marginal rate of substitution and the market values of “X” and “Y” at the point of equilibrium.) Now, you suddenly crave good “X” much more relative to “Y” than previously. this do to your indifference curve and equilibrium position? Why? After you crave more “X” relative to “Y”, the price of “X” rises dramatically. your graph what does this do you your equilibrium position?

Now, your income doubles.

What does

Draw on

Graph your new equilibrium position.

By doing this exercise, you get a sense of how your real income and purchasing power, and consumption changes, as your tastes, income and market conditions change. Remember there are three components here:

Your psychological makeup – your indifference curve

Your income – the result of all your hard work and application of skills The prices you face, determined by the market.

In the “real world” this is a situation that will always hold true for you as you interact with the world of goods and services.

At the equilibrium, the MRS=price ratio = PX/PY. At the equilibrium, the indifference curve is tangential to the budget line.

MRS =MUX/MUY =PX/PY,

i.e. MUX/PX = MUY/PY

Now it is given that X is “craved” much more for relative to Y. Hence the indifference curves becomes steeper. That is now you are willing to give up

more amount of Y to have a unit more of X. Alternatively, it can be said that you need more of Y to leave you indifferent for the same decrease in X.

Hence the slope of the indifference curve, i.e. the marginal rate of substitution increases, i.e. MUx/MUY increases.

We know that the price ratio doesn’t vary.

Hence at the original equilibrium, we have MUX/PX>MUY/PY.

Therefore you will consume more of X and less of Y at the new equilibrium, since your receiving more from the last dollar spent on X than Y.

Now the price of X rises. Since we are at an equilibrium, MUX/PX=MUY/PY. But since Px is higher, your budget curve pivots inward. With the substitution effect you consume less of X and more of Y. With the income effect you consume less of both goods (since real income has decreased). Therefore at the new equilibrium, you consume less of X and the amount of consumption of Y depends on the relative strength of the two effects.

(5) Think of a commercial establishment (department store, coffee shop, gas station, store from which you make common purchases – that is spending your hard-earned money) and think through the questions in the previous exercise (4) as they would apply yourself and to the goods offered by this establishment. That is, take any two goods or groups of goods from the store you have chosen and re-do the questions in (4) as they would really apply to you and your tastes. Now you are thinking economics and thinking creatively as well! Consider choice made between having fruit beer(X) or having ice cream(Y) after dinnerassuming that both are good goods. At the equilibrium, the MRS=price ratio = PX/PY. At the equilibrium, the indifference curve is tangential to the budget line.

MRS =MUX/MUY =PX/PY,

i.e. MUX/PX = MUY/PY

Now it is given that X(fruit beer) is “craved” much more for relative to Y(ice cream). Hence the indifference curves becomes steeper. That is now you are willing to give up more amount of Y to have a unit more of X. Alternatively, it can be said that you need more of Y to leave you indifferent for the same decrease in X.

Hence the slope of the indifference curve, i.e. the marginal rate of substitution increases, i.e. MUx/MUY increases.

We know that the price ratio doesn’t vary.

Hence at the original equilibrium, we have MUX/PX>MUY/PY.

Therefore you will consume more of X and less of Y at the new equilibrium, since your receiving more from the last dollar spent on X than Y.

Now the price of X rises. Since we are at an equilibrium, MUX/PX=MUY/PY. But since Px is higher, your budget curve pivots inward. With the substitution effect you consume less of X and more of Y. With the income effect you consume less of both goods (since real income has decreased). Therefore at the new equilibrium, you consume less of X and the amount of consumption of Y depends on the relative strength of the two effects. (6) You are willing to accept risk for rewards.

For example, you are willing to take real tough courses at UCD because if you do well, it will look like you are a hard worker on your transcript (and that is a good thing). Okay, the reward is what could be on your transcript but the risk is that you MAY pull down your GPA. Draw an indifference curve for your two “goods”, risk and reward for your decision to take or not take the hard courses. Put the good, reward, on the X axis. What do micro-economists call these two goods with respect to the indifference map?

Now, suddenly you are really afraid to take the hard courses (that is, you now have a greater fear of failure). How does that change your indifference map? You have upward sloping indifference curves between risk and reward, i.e. for a given level of utility; if you face more risk then you require more rewards to keep you at that level of utility. You consider risk to be a bad good while reward to be a “good” good.

Since you are afraid to take hard courses, you require more reward for taking the same risk to induce you to take that course. Hence the indifference curves become flatter. (7) The price of good X is $2. The price of good Y is $6. You have income of $30. In the case where you prefer to consume X, what will your indifference map look like? Give a numeric example of how much of the two goods you will consume in equilibrium. What will be the ratio of the marginal utilities of these two goods? What exactly will be the level of your utility at equilibrium?

At the equilibrium, your MRS equals the price ratio. Hence MRS=1/3. Consider the utility function, U(x,y) =xy. Hence MRS = y/x.

At equilibrium, x=3y. The budget equation is 2x+6y=30. Hence at the equilibrium, 12y=30, i.e. y=2.5 and x=7.5.

u(x,y) = 18.75.

(8) Automobile bodies and automobile wheels are perfect complements. Normally, four wheels are consumed for each body purchased. Draw the typical consumer’s indifference map for these two goods, auto bodies, and auto wheels. What can you say about the point of equilibrium for the typical consumer of these two items? Indicate the point of equilibrium on the diagram for lower and higher levels of personal income. At the point of equilibrium, a consumer consumes only an integer amount of the two goods. He consumes x cars and the corresponding amount of wheels, i.e. (4*x) since you require 4 wheels for each car. Your equilibrium is at the point where the budget curve is tangent to the indifference curve, i.e. at the kink of the IC’s.

Suppose a person has income sufficient to buy only one car. The his equilibrium point is at L. Compared to this a relatively higher income level individual will consume more number of cars, say like point H at his equilibrium.

(9) With respect to three goods – ice cream, green tea, and digital cameras, what does it means when your preference for, and satisfaction gained from, these three goods are consistent with the assumptions of completeness, transitivity, and (what I call) the “pig theory” of demand.

When preferences are said to be complete, it implies that you can rank the three goods in terms of your preferences between them. It can never be the

case that you don’t know your preference ranking between two goods.

When your preferences are said to be transitive then if you prefer x to y and then y to z, then it must be the case that you prefer x to z. If not then your preferences violate transitivity. If preferences satisfy completeness and transitivity then as the price of the good increases the demand for the good falls. This is the pig theory of demand. (10) What does it mean when we say that the MRS is A NEGTIVE VALUE on the indifference curve?

Indifference curves are downward sloping and the level of utility is constant along an indifference curve. As you give up some unit of the good on X axis, say X, you need more of the good on Y axis, say Y, to keep your utility level constant. Hence the slope of the indifference curve, which is the MRS, i.e. the ratio in which you are will to substitute one good for the other while remaining at the same level of utility, is negative. It is negative since as the amount of X decreases, Y has to increase. (11) If your equilibrium point between two goods X and Y is a CORNER SOLUTION, and you are on the X axis, what does that indicate about the relation between your personal MRS between X and Y and the market determined price ratio Px/Py? Why is this a corner solution?

In case of corner solution, at the equilibrium the price ratio and the MRS are not equal, unlike in the case of an interior solution. Since you are on X axis and hence consuming only X and zero amount of Y, the MRS =∞, i.e. no amount of Y can increase your utility level for the given level of X.

(12) If your equilibrium point between two goods X and Y is a CORNER SOLUTION, and you are on the Y axis, what does that indicate about the relation between your personal MRS between X and Y and the market determined price ratio Px/Py? Why is this a corner solution?

In case of corner solution, at the equilibrium the price ratio and the MRS are not equal, unlike in the case of an interior solution. Since you are on Y axis and hence consuming only Y and zero amount of X, the MRS =0, i.e. no amount of X can increase your utility level for the given level of Y.

(13)How might an indifference curve map indicate your personal preferences if you believe in the following:

Coke is just as good as Pepsi

You consider Pepsi and Coke to be perfect substitutes for each other and hence your indifference curves will be straight lines.

I hate rainy days and just love sunny days.

You consider rainy days to be bad goods. Given rainy days is on the vertical axis and sunny days are on the horizontal axis, your indifference curves are upward sloping with utility increasing along the horizontal axis.

Compared to everything else I could possible buy, I absolutely, positively want an Audi tt sports car.

Having an Audi is your satiation point or your bliss point. Hence your indifference curve are concentric circles around this point.

Baskin-Robbins Jamoca Almond Fudge® ice cream is so addictive. flavor is absolutely huge!.

My craving for this

If the fudge ice cream is on the horizontal axis, then your indifference curves are relatively steep, i.e. you are willing to give up the ice cream only if you receive relatively large amounts of the other goods in compensation.

I like ice cream, but under very few circumstances will I eat yoghurt. You consume ice cream and yoghurt in a particular combination. Hence these two goods are considered as perfect complements of each other but with greater weight on ice creams. Therefore your indifference curves are L shaped.

(14) Draw an indifference map where at your point of consumption your MRS between X and Y is 3 and the price of X is $1.00 and the price of Y is $1.00. Is there anything you can do to raise your level of satisfaction? If so, what is it? If increasing your utility is possible, where do you want to end up on the diagram and why?

The MRS =3 while the price ratio is =1. Hence you are not at the optimum. At the utility maximizing point we require MRS=PX/PY.

i.e. MRS=MUx/MUy = PX/PY,

i.e. MUx/Px=MUy/Py.

In this case we have,

MUx/Px=3 while MUy/Py =1.

Hence you are getting more utility from the last dollar spent on X than from Y. Therefore you can increase your utility by consuming more X and less Y.

(15) Draw an indifference map where at your point of consumption your MRS between X and Y is 1 and the price of X is $3.00 and the price of Y is $1.00. Is there anything you can do to raise your level of satisfaction? If so, what is it? If increasing your utility is possible, where do you want to end up on the diagram and why?

The MRS =1 while the price ratio is =3. Hence you are not at the optimum. At the utility maximizing point we require MRS=PX/PY.

i.e. MRS=MUx/MUy = PX/PY,

i.e. MUx/Px=MUy/Py.

In this case we have,

MUx/Px=1/3 while MUy/Py =1.

Hence you are getting more utility from the last dollar spent on Y than from X. Therefore you can increase your utility by consuming more Y and less X. (16) The Addictive Foods Corporation wants you do purchase and eat as much of its possible as is humanly possible. So Addictive Foods designs a pricing strategy to encourage this result. Given your own utility preferences for products of the type marketed and sold by Addictive, what is the likely shape of your budget constraint? Where might you end up on this constraint? If the pricing campaign is totally successful, where might most people end up on the constraint?

The budget constraint is likely to be relatively flat (assuming food is on the horizontal axis) since Addictive Foods Corporation would charge a relatively lower price. Given your preferences, you are likely to end up consuming relatively large amounts of food. If the pricing strategy is successful most people would end up to the right of the midpoint of their budget constraint, i.e. they would consume relatively large amounts of food. (17) The Greenie Energy Corporation wants you to conserve your household energy use – electricity and gas.

So Greenie designs a pricing strategy to encourage this result. Given your own utility preferences for the energy marketed and sold by Greenie, what is the likely shape of your budget constraint? Where might you end up on this constraint? If the pricing campaign is totally successful, where might most people end up on the constraint? The budget constraint is likely to be steep (assuming that energy is on the horizontal axis). Greenie Energy Corporation would charge a relatively high price to discourage usage of energy. Given your preferences, you are likely to end up consuming relatively small amounts of energy. If the pricing strategy is successful most people would end up to the left of the midpoint of their budget constraint, i.e. they would consume relatively small amounts of energy.

HW 2.

(1) What does “homogeneity” of demand mean? If the prices of all goods rises by 10% and you get a 10% income raise, what happens to your “real” income and purchasing power. If you were to represent this situation on an indifference map as you consumed goods X and Y, how would you show it?

Homogeneity of demand is x(p,m) = x(ap,am), i.e. as income and prices increase by same proportion, the demand remains unchanged.

If the prices of all goods rise by 10% and income increases by 10%, then your real income and purchasing power remains unchanged.

On the indifference map you remain at your initial equilibrium. (2) You consume two goods, X and Y. You really prefer X to Y. Also for you Y is an Inferior good. X is a Normal good. Starting from an initial position of equilibrium, you face a sudden rise in income. Go re-establish a new equilibrium. How would you represent all of this on your indifference map?

As your income increases, given that Y is inferior, you will consume less of Y and more of X. You move to a higher indifference curve and hence attain more utility since the budget set has expanded.

(3) You are in equilibrium on your indifference map with respect to X and Y. Your income does not change, but the price of X falls. You move to a new point of equilibrium on the indifference map. Show:

Where you end up if both X and Y are normal goods.

Where you end up if X is normal and Y is inferior.

Where you end up if X is inferior and Y is normal.

Now: Show the impact of the income and substitution effects with respect to your consumption of the good X in each of the three cases. Are the substitution effects different in each of these three two cases?

As the price of X falls you will consume more and X and less of Y under the substitution effect. This holds across the three cases. In case of X and Y being normal goods, a fall in the price of X increases your real income and hence with the income effect you consume more of both X and Y. At the new equilibrium you will consume more X and the amount of Y consumed depends on the relative strengths of the substitution and income effects.

In case of X being normal and Y being an inferior good, a fall in the price of X increases your real income and hence with the income effect you consume more of X and less of Y. At the new equilibrium you will consume more X and the amount of Y consumed falls. In case of X being an inferior good and Y being a normal good, a fall in the price of X increases your real income and hence with the income effect you consume less of X and more

of Y. At the new equilibrium your consumption of X and Y depends on the relative strengths of the substitution and income effects. For instance, if the substitution effect is stronger then you will consume more X and less Y.

(4) What is a Giffen Paradox? If the good X is subject to a Giffen Paradox, show with indifference curve, how you would respond to a sudden rise in the price of X. Show the income and substitution effects with respect to your consumption of X after the price rise.

According to the Giffen paradox as the income increases, you consume less of the good. For a given rise in price of X, the substitution effect induces you to consume less of X and more of Y. Since your real income has reduced, the income effect induces to consume more X (by Giffen paradox) and the consumption of Y reduces.

At the new equilibrium, the final consumption of X and Y depends on the relative strength of income and substitution effects. If the income effect is stronger, then you will consume more X and less of Y at the new equilibrium.

(5) Using indifference curve analysis, show how a TAX on the consumption of the good X can be less satisfactory from a satisfaction standpoint (utility standpoint) than a tax that raises the equivalent amount of money on income.

A tax on X changes the price ratio and budget curve pivots inward. Let e1 be the new equilibrium point. For an equivalent tax on income, the new budget line will pass through this point parallel to the original indifference curve. The indifference curve at the equilibrium e1 cuts the budget curve with tax on income. Hence you move to a new indifference curve which is tangential to the budget curve with income tax, with the new equilibrium lying to the right of e1 and hence on a higher indifference curve.

(6) Using indifference curve analysis, show how a unit TAX on the consumption of the good X that is completely reimbursed back to the consumer can lead to less satisfaction than before, even when the entire tax amount is handed back to the consumer.

(7) You are in equilibrium on your indifference map in your consumption of X and Y. The price of X drops. Show where you might end up if X and Y were complement goods. Show where you might end up if X and Y demonstrated substitutability.

In case of complementary goods, a fall in price of X results in increase in consumption of both X and Y in a given proportion (depends on the ratio in which you consume the two). In case of substitutes assume that the price ratio equals the MRS which implies that you are consuming positive amounts of both goods at your equilibrium. However once the price of X falls, it makes X relatively cheaper of the two goods and being perfect substitutes, you will spend your entire income on X and none of Y.

(8) Here is a question that deals with the notion of exogenous variables and your ability to consume goods and services.

Let’s say that you live on a Pacific Island with a bunch of other people. Let’s say as well is that your “profession” is to make and sell “wind kites”. This is a very desirable form of entertainment for the islanders. The market has determined the price of what you make (wind-kites), and the prices of all of the other things that you want to buy. You consume coffee and candy as goods X and Y. Your income is from the sale of wind-kites. You face two issues: First, you really want more coffee and candy than you can afford, and Second, some other people are out there also making wind-kites.

So, what do you propose to do to raise your “income” (push out your budget constraint) in order to consume more of these two items that you really crave? How would you represent your successful efforts on a two-dimension graph? What if the price of coffee skyrockets? What happens to your graph? What happens to your consumption of coffee and candy if both are normal goods? What additional steps might you take to maintain your purchasing power over the goods you demand to consume?

When it comes to your manufacture of wind-kites, can you think in what ways any accumulated knowledge and wisdom on the island (the past experience and efforts of other people) helps you in your profession?

Note: there are many possible answers to (8), but all follow a correct micro-economic logic. And this is an economic logic that we all face every day of our lives in the real world. I want to consume more coffee and candy but I am constrained by my budget. Hence to consume more of these goods I need to increase my budget, i.e. income and this can be done only by increasing profits from selling kites.

One is to reduce the cost of manufacturing the kites which will in turn lead to higher profit margins on each unit of kite sold. Also there are others selling wind kites. To increase sales revenue, I can also lower my price, but this requires the demand for kites to be inelastic and my price cut should not be matched by the other kite sellers.

If I can increase my income then I can consume more of the two goods and hence move to a higher indifference curve at the new equilibrium. However if the price of coffee increases, then under the substitution effect I consume less of coffee and more candy. But my real income has fallen and thus the income effect induces me to reduce consumption of both goods. At the final equilibrium, I will consume less coffee. The relative consumption level of candy depends on the strength of substitution effect relative to the income effect.

If I can make use of accumulated knowledge and wisdom on the island, then it will help lower my costs of production and thus increase my profit margin on each unit sold.

(9) Simple, but important. What is the difference between a “shift in demand” (an increase or decrease in demand) and a “change in the quantity demanded”? What do these concepts have to do with endogenous and exogenous variables?

A shift in demand implies movement along different demand curves. A demand curve shifts when an exogenous variable changes.

A change in quantity demanded is a movement along the demand curve.

A change in demand occurs when the endogenous variable varies.

(10) Now here is a challenge. If you can work through the answer to this problem and understand it, you will have an insight as to what can drive national economic and most especially foreign policy of a country like the United States. The GDP of the USA is almost 70% consumption of goods and services by individuals. It is desire and possibility to consume all these goods that provide incentives for businesses to make the goods and therefore provide employment and income for hundreds of millions of people. Just about all of the goods that we consume and use in the USA are made with petroleum (oil) as an input. Soap, plastics, machines, medicines, and (obviously) gasoline and diesel fuel are examples. Suppose we had an indifference curve that showed the relationship between the consumption of all oil and oil-based goods (X) and all other goods (Y) for all Americans.

Show what would typically happen in terms of income effects, substitution effects, and welfare loss if the US suddenly faced a large rise in the price of imported oil. A large rise in the price of imported oil would make imports relatively expensive. Given that 70% of income is spent on imports, the increase in price of imports significantly reduces the purchasing power of income and you move to a lower indifference curve. Hence there is a large reduction in welfare.

(11) An issue facing just about all consumers (ALL OF US) is that of trying to move out the budget constraint (increasing purchasing power through a rise in income). I admit, I want that too. Using indifference curve analysis, we see how movements in income can “compensate” for price changes.

Let’s say you were faced with a rise in the general price level for the goods you desire to consume. How would this impact your position in the budget-constraint indifference curve diagram? Now, remembering the diagram about earnings and wage-power that I put on the board in an early lecture, think of ways that you could try to remedy this situation, right now? Remember the three factors that will determine how much purchasing power you will have over the goods and services that others in the community produce (should you WANT to consume them).

What resources are there in the community that can help you solve this problem? (This is a very practical and real-life question that should make our ECN 100 theory more relevant to you.)

A general rise in the price of goods would shift the budget constraint inward, i.e. your budget set contracts since the purchasing power reduces. This induces you to move to a lower indifference curve.

The lower purchasing power can be compensated for by increasing the number of hours worked (i.e. by reducing leisure enjoyed). Alternatively, you can invest your income in inflation-indexed bonds which will prevent your purchasing power from decreasing.

(12) Which of the two phrases that follow would indicate a demand curve moving vertically or horizontally? An article that coffee is healthy results in people drinking more coffee at any price.

An article that coffee is healthy results in people wanting to pay more for coffee no matter how much they drink. The first article indicates a shift of the demand curve. The article induces people to change their tastes and hence consume more coffee at the same price. (13) If he price of coffee rises from $3 to $4 per pound and as a result you lower your consumption of coffee from 4 pounds per week to 3 pounds per week, what is your personal elasticity of demand for coffee? Is your demand elastic or inelastic at this point? The elasticity is given by e=(dQ/dP)/(P/Q) = -1*(3/4) =0.75. Your demand is inelastic at this point since ebagels purchased? What can Noah expect to happen to his total revenue earned after this price increase of the bagel? Why would a typical business desire a demand curve for its product that is as least elastic or as inelastic as possible?

We can assume that the price elasticity for Noah’s Bagels is inelastic if it is less than 1. We can define price elasticity as, e= (% change in demand)/(%change in price). Since demand is inelastic, e

If the price elasticity of demand is inelastic, then as the price increases, the total revenue will increase. If the price elasticity of demand is elastic, then as the price increases the total revenue falls. For unitary elastic demand, for changes in price, the total revenue remains unchanged.

(16) If a linear demand curve has a slope of One, what is the value of the price elasticity of demand on this demand curve at its midpoint? What is the value of the price elasticity on the curve above the midpoint? Below the midpoint?

For a linear demand curve of slope=1, we have dQ/dP=1.

At the midpoint, P=Q. Hence e=(dQ/dP)/(P/Q) =1.

For any point above the midpoint, P>Q, thus e>1 and for any point below the demand curve, P changes for coffee, why is it that the demand curve would ALWAYS be downward sloping. Show how this demand curve would be determined using the indifference map and budget constraint diagram for a typical coffee consumer. The substitution effect induces the consumer to consume more of the relatively cheaper good. Hence as the price of a good increases you will substitute away from it. Hence the demand curve under the substitution effect is downward sloping.

An increase in the price of X pivots the budget curve inwards around the vertical intercept. To capture the substitution effect, a new budget curve where the real income is held constant is defined. The initial equilibrium is at e0. For the budget curve to the right of e0 lies below the original budget curve and hence was already affordable. Hence the consumer will consume to the left of e0 under the new equilibrium. Hence as the price of X increases, the substitution effect induces the consumer to reduce the consumption of X. (19) Let’s say the commodity “X” is a Giffen Good. Using the indifference map and budget constraint for the typical consumer of this good, show how the combination of the substation and income effects results is an UPWARD SLOPING demand curve for “X”.

For a given rise in price of X, the substitution effect induces you to consume less of X and more of Y. Since your real income has reduced, the income effect induces to consume more X (by Giffen paradox) and the consumption of Y reduces.

At the new equilibrium, the final consumption of X and Y depends on the relative strength of income and substitution effects. If the income effect is stronger, then you will consume more X and less of Y at the new equilibrium. Hence as the price of X increases, you consume more of X and hence the demand curve is upward sloping.

(20) This next question is related for (6) above and is repeated for emphasis. Your government wants you to consume less Coffee. It believes that the caffeine in coffee is harmful to your health. Thus, your government decides to place a tax on your purchase of coffee. Coffee is a NORMAL good. This tax is a FIXED PERCENTAGE of the price (amount of money) you pay to this product. For every dollar you spend on coffee, you pay a “t” percent tax on that dollar. Therefore the more money you spend on coffee, the more tax you pay.

BUT, your government feels sorry for you and decides to rebate back to you the tax you pay on the coffee that you purchase (all of it). With the rebate, you can do what you wish. Please use the tools we have developed thus far in the course to show: (1) The original consumer equilibrium before the tax and the impact of the tax on the budget line and the new consumer equilibrium after the imposition of the tax. (2) The impact of the tax rebate on the consumer and the new consumer equilibrium after the rebate.

(3) How the new consumer equilibrium with the rebate leaves the consumer “worse off” than had the tax not been levied in the first place.

Since you are moving to a lower indifference curve after the rebate, you are worse off under this system.

(21) If potatoes are an inferior good, how would we show that to be the case using a simple calculation of the income elasticity of demand for potatoes? Income elasticity can be defines as, ei = (dQ/dI)/(I/Q).

Since potatoes are inferior goods, as the income increases you consume less of it, i.e. (dQ/dI)

Assuming that the demand is linear, i.e. it is a straight line joining (0,10) and (10,0), the consumer surplus for P=5 will be half the area of the triangle enclosed by the demand curve. Hence consumer surplus = ½*[1/2*10*10] =$25.

Consumer surplus on a unit sold is the difference between what the consumer is willing to pay for that less the amount he actually has to pay. Therefore the lower the price he has to

actually pay relative to his willingness to pay, greater is his consumer surplus and hence greater the welfare.